Monthly Archives: January 2017

New Keynesian Economics

New Keynesian Economics

  • Founded with an attempt to build microeconomic foundations for Keynesian economics
    • Particularly sticky wages and prices
    • Why are changes in aggregate price level sticky?
    • Why don’t price changes mimic changes in nominal GNP?
    • Regards the choices of monopolistically competitive firms that set their individual prices to accept the level of real sales as a constraint.
      • Firms do not assume that marginal costs will move in parallel with aggregate demand
    • What are sticky wages and prices, exactly?
      • Sticky wages are when worker’s earnings don’t adjust quickly to changes in labor market conditions. (ex. Wages won’t go down in a recession and rise in an expansion. Instead we experience unemployment in recessions)
      • Sticky prices are when prices do not respond immediately to changing economic conditions. Haircuts have a sticky price, while gas prices do not.
    • Believe that many markets are imperfectly competitive and have a degree of monopoly power
      • Businesses have the opportunity to be more flexible with pricing
    • Believe RIR differ from nominal IR (like the monetarists?)
    • Recognize necessity for monetary and fiscal policy
    • Heavy reliance on DSGE models
      • Taylor rule: optimal interest rates given the given rate of inflation and the output gap
      • Hit target inflation and you will have optimum growth and employment (hello Janet Yellen)
    • Reasons for sticky prices:
    • Staggering of prices. Firms may respond to changing prices slowly. If one firm cuts price of raw materials, it may take a few months for retailers to pass this cost saving onto consumers.
    • Demand is inelastic in imperfect competition, there is no incentive to cut prices as revenue falls.
    • Reducing prices can increase real incomes for consumers, which might be spent on other goods (firm doesn’t benefit)
  • Reasons for sticky wages:
    • Trade unions resist wage cuts for their workers.
  • Workers are mainly concerned about their wage, and not the overall level of employment
  • Cutting wages may reduce worker morale and reduce productivity.


DSGE, Monetarism, Keynesianism, and Schools of Thought

DSGE models: attempt to explain aggregate economic phenomena (growth, business cycles, effects of monetary and fiscal policy)

Dynamic (studies how the economy changes over time), stochastic (takes shocks like price changes, technology changes into affect)

Key components:
• Preferences
• Technology
• Institutional framework
• Rational expectations

Schools of thought that use DSGE models:
• Real business cycle
• New Keynesian

Schools of thought:

• Economy’s performance is determined by changes in the money supply
• Economic well being can be adjusted by changes in the money supply

Important things to monetarists:
• Long run neutrality and short run money non-neutrality
o Money is neutral in the long run if the supply and demand choices of people reflects only concern for the underlying quantities of goods and services that are consumed or produced
o Short run money non-neutrality means that changes in money supply take place very gradually (RBC economists don’t think this exists)
• Distinction between real and nominal interest rates
o Real interest rates take expected inflation into account, as rational people would do as they make trade offs between the present and the future.
• M1 and M2
• No permanent tradeoff between unemployment and inflation
• Monetary policy is more potent than fiscal policy when it comes to stabilizing the economy

Not widely practiced today.

• Focused on the effects of aggregate demand on output and inflation
• Stressed the importance of fiscal policy, and the powerlessness of monetary policy (not actually a thing anymore)
• Changes in aggregate demand have their greatest effect on real output and unemployment, not on prices. (Phillip’s curve)

Things important to Keynesians:
• Sticky prices and wages
• Increases in government spending causes an increase in output
• Prices, and especially wages, respond slowly to changes in supply and demand, resulting in periodic shortages and surpluses, especially of labor.